Options: Types and their Applications for Investors and Traders
Options are an important tool in the financial markets, providing investors and traders with flexibility in managing risk and profit opportunities. Understanding the different types of options and their applications can greatly improve the effectiveness of investment strategies.
What is an option?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike) at a specified time in the future. The seller of the option, in turn, undertakes to fulfill the terms of the contract if the buyer decides to exercise their right. This is different from futures, where both parties are obligated to fulfill the terms of the contract.
Main Types of Options: A Detailed Explanation
1. By Type: Call and Put
Call Option
A Call option gives the buyer the right to buy an underlying asset (such as a stock, commodity, or currency) at a predetermined price (strike) in the future. This means that the buyer can exercise their right if the market price of the asset at the time the option is exercised is higher than the strike.
Example:
Imagine that the strike price of a Call option on shares is 100 rubles. If the market price rises to 120 rubles, the buyer can exercise their right, buy shares at 100 rubles and lock in a profit of 20 rubles (excluding the premium). The seller of the option is obliged to sell the asset at the set price, even if the market price is significantly higher.
Put Option
A Put option gives the buyer the right to sell the underlying asset at a fixed price in the future. This right becomes profitable if the market price of the asset falls below the strike.
Example:
If the strike price of a Put option is 100 rubles, and the market price falls to 80 rubles, the buyer can sell the asset at 100 rubles, although its current value is only 80 rubles. The seller is obliged to buy the asset at the set price, even if the market price is significantly lower.
2. By the method of paying the premium
Premium options
For premium options, the premium is paid in one lump sum at the time of purchase. Until the option is executed or expires, the value of the position is not revalued, and the variation margin (daily recalculation of profit or loss) is not accrued.
The peculiarity of this type is that the buyer immediately knows his costs for the option, and these costs are fixed. This makes premium options easy to understand and manage, which often attracts novice traders.
Margined options
In margined options, the premium is paid in parts through daily accrual of the variation margin. The position is recalculated daily depending on the change in the price of the underlying asset, which makes this instrument more dynamic.
Example:
If the price of the underlying asset rises, the premium may increase, and the buyer will have to transfer additional funds in the form of margin. This makes margined options less predictable, but more flexible for professional traders.
3. By execution method
American options
An American option gives the buyer the opportunity to exercise the contract at any time before the expiration date. This flexibility can be useful if the price of the underlying asset changes dramatically before the expiration date of the option.
Example:
If an investor owns an American call option with an expiration date of three months, he can exercise it in a month if the market price has become significantly higher than the strike price.
European options
A European option can only be exercised on the expiration date of the contract. This restriction simplifies risk management for the seller, since he knows for sure that the option can only be exercised on a pre-agreed date.
Example:
If the price of the underlying asset changes a few days before expiration, the owner of the European option will not be able to take advantage of this change until the expiration date.
4. By calculation method
Delivery Options
When a delivery option is exercised, the underlying asset is physically transferred to the buyer. This type is used when ownership of the asset itself is important to the participants. For example, a delivery option on gold implies the actual transfer of the metal to the buyer's account.
Cash-settled Options
Settled options offer a cash settlement of the difference between the strike price and the market price instead of transferring the asset. This approach simplifies the calculations and eliminates the need to own the asset.
Example:
If you bought a cash-settled Call option with a strike price of 100 rubles, and the market price at the time of exercise is 120 rubles, you will receive a cash payment of 20 rubles (minus the premium), and not the asset itself.
Each of these types of options has its own characteristics and is suitable for different purposes - from speculating on price changes to hedging risks. Understanding these characteristics allows investors and traders to choose instruments that best suit their strategy and market conditions.
Using Options: A Detailed Description
1. Speculating on Price Changes
Options provide an opportunity to profit from changes in the value of an underlying asset without buying the asset itself. This makes them an attractive tool for investors looking to use price fluctuations to their advantage.
Using a Call Option:
If an investor expects the price of an underlying asset to rise, they can buy a Call option. This option gives the right to buy the asset at a fixed price, which will be lower than the market value if the price rises. The difference between the strike price and the market price becomes the investor's profit.
Example:
An investor buys a Call option on a stock with a strike price of $50, expecting it to rise to $70. If this happens, they can buy the stock at $50 and immediately sell it at the market price, locking in the profit (minus the premium).
Using a Put Option:
If an investor expects the price of an underlying asset to fall, they can buy a Put option. This tool allows you to sell the asset at a fixed price, which will be higher than the market value.
Example:
An investor buys a put option on oil with a strike price of $80, expecting it to fall to $60. If the price falls, he can sell the oil at $80 and make a profit of $20 per barrel (excluding the premium).
2. Hedging Risks
Options are often used to protect a portfolio from adverse price changes. This is especially important for long-term investors and companies exposed to market risk.
Put Option Example:
An investor who owns a stock might buy a put option to hedge against a fall in the stock's price. If the stock's price falls, the loss from the fall is offset by the gain from the option.
Example:
A company that imports oil might buy put options on oil to hedge against a fall in its value if oil prices fall.
Example with a Call Option:
Companies that use raw materials can hedge against rising commodity prices by buying Call options. If prices rise, the profit from the option will offset the additional cost of buying the raw materials.
3. Earning a Premium
Selling options allows you to earn a premium, which makes this approach attractive to traders, especially in stable markets. Option sellers are obligated to fulfill the contract if the buyer exercises their right, and the premium becomes their fixed income.
Example of a Premium Earning Strategy:
If a trader believes that the market will remain stable and prices will not change significantly, they can sell Call or Put options. If there is no significant movement, option buyers will not exercise their rights, and the premium will remain with the seller.
It is important to remember, however, that the option seller has obligations, which makes this strategy risky in highly volatile conditions.4. Построение опционных стратегий
Traders can combine different options to create complex strategies to manage risk and profit in certain market conditions.
Spreads:
Spreads are a combination of options of the same type (Call or Put) with different strike prices. This strategy allows you to limit losses by sacrificing some of your potential profit.
Example:
A trader buys a Call option with a low strike price and sells a Call option with a higher strike price, reducing the overall cost of the strategy.
Straddles:
A straddle involves buying both a Call and a Put option with the same strike price and expiration date. This is suitable for highly volatile markets where large moves in either direction are possible.
Example:
If a trader expects the price of an asset to move wildly but does not know the direction, they can use a straddle to make a profit regardless of the price movement.
Strangles:
Similar to straddles, but options are purchased at different strike prices, making the strategy more flexible.
Advantages of Using Options: A Detailed Explainer
1. Capital Efficiency
Options allow investors and traders to enter into positions at a lower cost than directly buying or selling the underlying asset. This is especially useful for those who want to gain exposure to the market with limited capital or who are looking to diversify their portfolio.
Example:
Suppose a stock is priced at $100. It would cost $10,000 to buy 100 shares. However, buying a Call option on the same stock with the right to buy it at a strike price of $100 might cost, for example, $200 (the premium). This means that it only takes $200 to participate in a stock’s price increase instead of $10,000.
Result:
This approach frees up the remaining funds for other investments, increasing the return potential of the entire portfolio.
Use in diversification:
Investors can spread capital across several options on different assets, reducing overall risk and increasing the opportunity for profit.
2. Flexibility
Options offer a wide range of strategies that can be adapted to any market conditions - rising, falling, or even stable. This flexibility makes options a versatile tool for investors with different goals.
Example of a strategy in a rising market:
If an investor expects an asset to rise, he can use a Call option to profit from the increase in price.
Example of a strategy in a falling market:
Put options can be used to protect against a decline in the value of the portfolio.
Complex strategies:
Combining different options allows you to create strategies such as spreads or straddles that are suitable for working in volatile markets.
Straddle example:
An investor buys a Call and a Put with the same strike prices. If the asset price changes sharply in either direction, he will be able to lock in the profit.
3. Limiting risks
One of the key advantages of options is the ability to limit losses. The option buyer knows in advance that the maximum risk is limited to the amount of the premium paid. This makes options attractive to those who want to minimize risks.
Call option example:
An investor buys a Call option with a premium of $200. If the asset price falls below the strike price, the maximum loss will be only this premium - $200.
Put option example:
A trader who owns shares buys a Put option to protect against a fall in their value. If the stock price declines, the loss will be offset by the gain from the option, and the premium will be the only cost.
Importance for hedging:
Options are widely used in corporate finance to protect against market risks, such as changes in commodity prices, foreign exchange rates, or interest rates.
Risk control:
Unlike other derivatives such as futures, buying options involves no liability or liquidation risk.
Options are a truly powerful tool for managing finances and investing. They provide incredible flexibility and a wide range of opportunities for both novice investors and professional traders. From minimizing risks and using capital efficiently to building complex strategies, options can be adapted to almost any market conditions.
However, it is important to remember that working with options requires a deep understanding of their mechanics and a competent approach to risk management. Lack of knowledge can lead to losses, so to successfully use this tool, it is necessary not only to understand the theory, but also to analyze the market, assessing your capabilities and goals.
As the founder of Open Oil Market, I am convinced that financial literacy and the ability to use modern tools are the keys to success in any field. Use options responsibly, expand your knowledge and apply it wisely to achieve your goals. Good luck with your investments!
